What’s Worth More: Safety or Profit?

Would you lend a friend $100 if he promised to pay you back $99 within a year? Even if you had every confidence that your friend would pay you back, you’d be losing one percent of your “investment,” as well as tying up a much larger amount for 12 months. Personally, I might do it if my friend needed the money, but I wouldn’t consider it an “investment,” since it’s clearly a lousy deal for me financially.

Yet that’s exactly the deal investors are clambering for today in Europe, where yields on many government bonds have dropped below zero. Germany sold $3.72 billion of new five-year bonds last month at an average yield of negative 0.08%. Two-year French bonds are currently yielding negative 0.13%, and in Switzerland even 10-year bonds are yielding negative 0.09%. Bonds issued by the Netherlands, Austria, Denmark, Sweden and Finland have also traded at negative interest rates.

While there are reasons for this that technically make economic sense, it doesn’t make common sense to most of us. Just as most people wouldn’t lend a friend $100 in exchange for $99 a year later, most investors don’t understand why you’d willingly lend your government money for a guarantee of less money back.

To understand why this situation arose, you have to start by considering supply and demand-the supply in this case is the amount of debt these governments are willing to issue, which is limited. (That inelasticity is reflected in the steep slope of the red line in the graph below. The supply of government debt is affected by the yields the government can get for its debt, but not strongly. The government’s need for funds is more important.)

The demand side of the equation is determined by investor appetite for government bonds, which is currently very high. Partially, that’s because investors are concerned about the health of European economies, which makes investments like European stocks riskier and less appealing. These risk-averse investors are gravitating to the safest investments they can find, which include debt issued by economically solid northern European countries.

That’s why right now, for many types of government bonds, the limited supply and high demand are intersecting at a negative interest rate. The governments involved don’t have to offer higher rates, because there’s more than enough demand for their debt at the current negative rates.

That’s the simple supply and demand explanation. On top of that, the European Central Bank recently started its own bond buying program, much like the Fed’s quantitative easing or “QE” of the past few years. The ECB is trying to stimulate growth by buying government bonds, which will drive down interest rates on government debt as well as other types of lending. That makes it more attractive for lenders to make private loans, and for businesses and people to borrow money-which then can be used to start businesses, hire employees, build houses and do other things that create economic growth.

Obviously low yields on government debt are an intended consequence of this program, but while the ECB is aiming for “nice and low” yields in countries that need economic boosts, like Greece and Portugal, that means driving yields into negative territory in much of northern Europe. The debt of stronger, more fiscally conservative countries like Germany is seen as much safer than the debt of more profligate, slower-growing countries like Spain, so German debt is naturally going to yield less than Spanish debt. The ECB is buying a broad basket of debt, but driving down yields in Spain also drives down yields in Germany-and so we wind up with negative yielding German bonds.

But even once you understand why yields on some European debt are so low, you still probably want to know why anyone is buying it. Why pay 0.08% to lock up your money in German bonds for five years when you could put it under the mattress for free?

The most likely reason: you don’t have a big enough mattress.

You or I can convert our money to cash if there are just no good investment opportunities out there, and keep it in a bank account or a safe deposit box. But pension funds, mutual funds, banks and big companies that have billions of euros to invest don’t have that option. Most ordinary bank accounts are only government insured up to 100,000 euros, and putting billions of euro bills in a lockbox is hardly feasible. And banks themselves by law have to store some reserves with a government-run central bank. Since the ECB is currently charging them to store “excess” reserves, most are parking some of their excess cash in government bonds.

Lastly, many passively-managed institutional funds are required by their own rules to hold a percentage of their assets in a certain types of ultra-safe bonds, so they’re major buyers of government bonds regardless of interest rates. You might expect all the investors in these funds to sell their shares if the returns are so bad, but many of these accounts-such as pensions and institutional retirement accounts-are not actively invested.

And that’s why Switzerland is able to charge investors for the privilege of lending its government money.

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Your Private Invitation to Profit
From Our Best Dividend Stocks

When we launched Cabot Dividend Investor last year, we knew it would be incredibly successful. After all, our back-tested retirement income system generated a 326% total return and a 14% yield on cost in five years.

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Moving on, it’s time for the next installment in my ongoing series, Best High Dividend Utility Stocks.

Utilities have long been considered “widow and orphan stocks” for their slow, steady returns and low volatility. While they’re never going to grow fast enough to be hot stocks, utility companies usually operate legal monopolies in their market area, and don’t have to worry about losing customers. Utilities in faster-growing regions may grow faster than average, while utilities in slower-growing regions may struggle. And economic conditions can temporarily affect demand levels for electricity and other utilities. But long term, utilities usually manage to achieve annual earnings and revenue growth in the mid-single digit range.

This reliability makes utilities good dividend payers. They have steady cash flows, so they can easily predict how much they’ll be able to afford to make in dividend payments. And they rarely cut their dividends during tough times, because utility demand will usually rebound long-term. The average utility yields between 3% and 4% per year, which is usually a pretty good return for the amount of risk you take on-especially today when other “safe” investments are charging you to hold them (see above).

Xcel Energy (XEL) is an electric and natural gas utility that operates in Colorado, Michigan, Minnesota, New Mexico, North Dakota, South Dakota, Texas and Wisconsin. The company just raised its dividend for the 11th consecutive year and the stock currently yields 3.7% per year. Management has said that its long-term goal is to grow both earnings and the dividend by 4% to 6% annually.

The company is making major investments in upgrading existing power plants and building new infrastructure, both to grow earnings and to ensure compliance with environmental regulations. One major initiative underway is the creation of two subsidiary companies called Transcos that will bid on and build transmission projects outside Xcel’s service territory, as allowed by new Federal regulations.

These investments are being funded by a combination of debt and equity. Xcel issued $175 million of new equity last year, but management said in the latest conference call that they aren’t planning to issue any more equity for at least the next five years. Xcel’s debt to equity ratio of 1.1 is in line with the industry average. The company’s debt is all investment-grade.

Be aware that the whole utility sector is still getting thrashed by expectations of an interest rate increase: if the Fed makes an announcement without the word “patient” next week you can be sure utilities will take another dive. But this investment is about reliable long-term returns, not short-term gains. XEL is a good choice for investors looking to add an income-generating utility to their portfolio-just be aware of the downside risk and likelihood of heightened volatility until the Fed raises rates.

For updates on Xcel Energy and additional high dividend stocks, consider taking a risk-free trial subscription to Cabot Dividend Investor.

Cabot Wealth Advisories

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Market Update

From Cabot Top Ten Trader

The overall market is still in good shape, but growth stocks have been acting funky for a couple of weeks, and today the sellers were out in force, driving the Nasdaq and many leading stocks to big losses. We're not advising wholesale selling because many stocks look just fine, but you should honor your stops and make sure no losses get out of hand. We're moving our Market Monitor to a level 7 (out of 10) and will see how the market reacts from here.